The Tax Institute welcomes the opportunity to make a submission to the Australian Taxation Office (ATO) on the consultation on draft Practical Compliance Guideline PCG 2026/D4: Royalty characterisation of payments relating to intermediation or distribution arrangements – ATO compliance approach (Draft PCG).
In preparing this submission, we consulted with our National Large Business and International Technical Committee to develop a considered response that reflects the views of the broader membership of The Tax Institute.
We acknowledge the ATO's objective of providing clarity on the royalty character of payments made under software intermediation and distribution arrangements, and of directing compliance resources towards cross-border arrangements structured to reduce or avoid tax on profits connected with Australia. We also recognise the value of the expanded safe harbours in the Draft PCG, which are intended to reduce compliance costs for lower-risk arrangements.
The Draft PCG is a useful step towards greater certainty for common software distribution arrangements. However, in its current form, it raises several issues that warrant further consideration, including aspects of the risk assessment framework, uncertainty regarding the interaction with existing ATO guidance, and certain safe harbour settings.
Summary of key concerns
Our key observations in response to the Draft PCG are set out below:
The Draft PCG is incongruent with ATO guidance in PCG 2019/1
We note several issues in this respect:
- the 10% threshold in the first limb of paragraph 42 sits well above, and is not aligned to, the profit markers already used to assess transfer pricing risk for ICT distributors under Practical Compliance Guideline PCG 2019/1: Transfer pricing issues related to inbound distribution arrangements (PCG 2019/1) and the Draft PCG does not explain the basis for the difference;
- the second limb of paragraph 42 ties an Australian taxpayer's risk rating to the profitability of its global group, producing different outcomes for taxpayers with identical Australian facts and identical arm's length returns; and
- the Draft PCG does not confirm whether ‘operating margin’ in paragraph 42 is the same measure as the five-year weighted average Earnings Before Interest and Tax (EBIT) margin used in PCG 2019/1, or define the ‘global group’ used in the second limb. Paragraph 42 refers to the margin ‘for a relevant income year’, which suggests a single-year measure.
The amber and red zone defaults are easily conflated
The Draft PCG’s two default outcomes can be easily conflated. The red zone default for not undertaking the residual risk assessment calculation appears only in Table 2, not in the red zone criteria at paragraph 46, and sits uneasily with the amber zone default at paragraph 44.
The interaction with PCG 2019/1 ratings and Subdivision 815-B is unclear
The Draft PCG does not confirm whether a PCG 2019/1 rating has any bearing on the rating under the Draft PCG, or that a taxpayer will not be disadvantaged in its risk rating for keeping its pricing within its arm’s length range, consistent with Subdivision 815-B of the Income Tax Assessment Act 1997 (Cth), rather than pricing above that range to access the paragraph 42 exception.
The green zone draws an arbitrary distinction between once-off and subscription payments in simple distribution arrangements
It is unclear why a distinction is drawn at paragraph 36 of the Draft PCG between once-off and recurring subscription payments for software in simple distribution arrangements. The Draft PCG does not explain why these different approaches change the nature of the underlying arrangement when all other facts remain the same.
The green zone safe harbour thresholds for recognised royalties are high
The green zone safe harbour thresholds at paragraph 37 of the Draft PCG for when a royalty is recognised in relation to software purchased from an offshore supplier should be reconsidered, as they are not consistent with the Draft PCG’s own description of a reasonable royalty rate at paragraph 20, or with industry experience. Footnote 7 to paragraph 38 indicates the threshold percentage remains open.
Unclear as to whether ‘substantially customised’ is a test for the green zone
Example 3 of the Draft PCG applies a ‘not substantially customised’ standard in classifying an arrangement in the green zone, while paragraph 35 refers to software that is ‘not customised’. This creates uncertainty as to which standard forms part of the risk assessment.
Our detailed response and recommendations to improve the Draft PCG are contained in Appendix A.